The Big Short is a Great Movie, But...

Paris -- Michael Lewis is the chronicler of Wall Street.  He takes the complexity behind which the inhabitants of the financial world hide and weaves a tale that is both understandable and compelling.  Starting with the classic “Liars Poker” (1989), Lewis has produced a number of books about the financial markets including “Flash Boys: A Wall Street Revolt” (2014) and “The Big Short: Inside the Doomsday Machine” (2010).  Working with director Adam McKay and some great actors and screen writers, Lewis has managed to produce what is perhaps the most accessible and relevant treatment of the mortgage boom and financial bust of the 2000s, and the subsequent 2008 financial crisis.

The beauty of “The Big Short,” both as a movie and a book, is that it provides sufficient detail to inform the general audience about events and issues that are not part of everyday life.  Wall Street is a secretive place, but “The Big Short” manages to convey enough of the details to make the story credible as a journalistic effort, yet also enormously entertaining.  Lewis does this with two essential ingredients of any film: a simple story and compelling characters.

Images of greed and stupidity are presented like Italian frescos in “The Big Short,” pictures that are memorable and thought provoking.  Indeed, what many people know and remember years from now about the 2008 financial crisis will be shaped by creative efforts such as “The Big Short” for the simple reason that Lewis has simplified the description into a manageable portion.  Unlike hedge fund manager Michael Burry (played by Christian Bale), most people lack the patience and expertise to sift through and understand reams of financial data.

Fund manager Michael Baum (played by Steve Carrel) is likewise a perfect caricature of the Wall Street loner, the contrarian personality who looks for situations where everyone in the crowd is headed in one direction – a sure sign that they are wrong.  Baum’s willingness to take on the big banks – including the firm that sponsored his hedge fund – illustrates how difficult it is for a contrarian to prevail when all of the mega institutions on Wall Street are betting against you.  Then we have the delicious irony of banker and narrator Jared Vennett (played with evil delight by Ryan Gosling) betting against his own firm by facilitating short sales of toxic derivative mortgage securities.     

“The Big Short” has rightly earned the acclaim of audiences and critics for presenting the sometimes seamy world of finance in a way that a broad audience can understand with relative ease.  As with any narrative of past events, the story must be simplified and summarized to make it manageable, either as a book or even more so as a film.  But here’s the rub: in order to tell the story, Lewis had to employ people and personalities to make his description accessible.  By doing so, he conveys to the audience only part of the story, emphasizing the role of people and leaving by the wayside the other, equally important and largely opaque institutional and legal aspects of the financial markets that enable fraud and skullduggery. 

For example, just why was it that firms like my old employer Bear, Stearns & Co, Lehman Brothers, Wachovia, Countrywide and others were originating sub-prime mortgages and selling securities based on this toxic waste? Did the employees and officers of these second tier firms just decide one morning to focus on the most problematic credits in the residential mortgage market at a time when every agency in Washington was encouraging home ownership and the Fed had cut interest rates to historical lows?  Stoking the mortgage boom via cheap credit, never forget, was a deliberate policy choice by the Housing Industrial Complex and the Federal Open Market Committee, a process accelerated following the shock of the 9/11 terrorist attacks.

In fact, the reason why these smaller financial firms became the mud-sucking bottom feeders of the world of mortgage finance was because the top four mega banks and their partners at the federal housing agencies in Washington the “GSEs”) had monopolized the prime mortgage market, both for loan originations and sales of government guaranteed mortgage bonds.  The big banks dominated the short-term funding market that piped liquidity to the likes of Countrywide, Washington Mutual and New Century Financial, none of which had sufficiently stable bases of liquidity to support their huge lending volumes. The housing GSEs, meanwhile, dominated the long end of the bond market, issuing securities at yields far below that possible for any bank or non-banks, large or small.

As the mortgage market crazed neared its peak in 2004-2005, the period when the anti-heroes of “The Big Short” began to realize that something was seriously amiss, the GSEs and big banks began to acquire exposures in sub-prime mortgages.  Indeed, the top banks by then had started to compete aggressively with the GSEs, pushing the market share of these three government agencies below 50% so that they could issue private mortgage bonds and derivatives at even bigger profits.  Today the housing GSEs account for virtually all mortgage lending in the US and the largest banks are actually exiting the market for making residential loans.

Government policy and the fact of the big bank-GSE monopoly in the market for prime mortgage loans drove the housing crisis as much or more that the stupidity and greed so skillfully portrayed in The Big Short. Because such details are the eye-glazing stuff of documentaries, not popular feature films created to drive Hollywood profits, Lewis could tell us only part of the story.  Part of the artistry of Lewis is that he understands that in the 21st Century, every successful book must be written as a potential movie script.

The same shortcoming affected the fascinating Lewis book “Flash Boys,” which tells a story of smart traders and computers giving the big Wall Street trading firms an advantage over small investors.  In fact, the “advantage” enjoyed by the big program trading firms is embedded in the myriad of complex order types of the New York Stock Exchange and NASDAQ – all of which are public and available to anybody with the knowledge to use them in their investment strategies.  But only a handful of traders and institutional investors have that knowledge.  Again, complexity, not just greed and avarice, are the drivers of financial contagion.

Another wonderful aspect of “The Big Short” is the way in which McKay explains the world of derivatives and complex financial instruments like the nefarious “credit default swap” or CDS using a casino as the foil.  CDS allows the characters in the story to bet against the subprime mortgage market.  Unlike a short sale of a stock or bond, though, a CDS truly is a gaming instrument that allows a speculator to sell something they don’t own and cannot borrow to deliver against the short sale.  Recalling the wisdom of Supreme Court Justice Louis Brandeis almost a century ago, an incomplete sale “imputes fraud conclusively.”  (Read our November 24, 2015 KBRA research note, “Can the Credit Default Swap Market be Salvaged?,” if you want to learn more about these dubious financial contracts.)

The casino scene in The Big Short exquisitely illustrates the way in which credit derivatives allow speculators to wager against different types of assets (and one another) without having to actually “complete” the sale as, say, with a short position in stocks like Apple (NASDAQ:AAPL) or Facebook (NASDAQ:FB).  All of the concerns with credit derivatives ultimately start with the simple fact that buying a CDS when one does not own or borrow the underlying bond is akin to "naked shorting" of stocks.  Sure, the short-sellers in the world of CDS must pay extortionate fees to their “bookie” to maintain their best over time, but a credit derivative allows speculators to create a short position that does not exist in the cash market and without any connection to the underlying basis for the trade.

What neither the book nor the film get around to telling us in full is that Washington’s embrace of gaming instruments like CDS not only helped the characters in the story bet against subprime mortgages, but also enormously amplified the scope of the 2008 financial crisis. By institutionalizing the use of CDS as an acceptable part of the world of investing, Washington made the mortgage boom and bust possible and far worse than a mere financial bubble in housing.  You get a hint of this near the end of the film when Carrel meets with his sponsor at Morgan Stanley and discovers that the firm has $14 billion in exposure to subprime debt via derivatives.  CDS allows the creation of massive risk that would otherwise not exist.

If Michael Lewis ever gets around to making a sequel to “The Big Short,” he should tell the story of how Fed Chairman Alan Greenspan, SEC Chairman Arthur Levitt, Senator Phil Gramm (R-TX), Treasury Secretary Lawrence Summers, and many others, conspired to attack and discredit Commodity Futures Trading Commission Chairman Brooksley Born in order to make the world safe for credit derivatives and the big banks that traffic in them.  This badly misguided action by these senior government officials make the acts of greed and stupidity so beautifully portrayed in “The Big Short” pale by comparison.  As we noted in the KBRA research note on CDS:

“[A]gencies such as the Federal Reserve Board in Washington have for decades publicly advocated the growth of OTC derivatives as activities that are appropriate for banks. When several large, internationally active banks began to expand into OTC securities and derivatives, and lobby in Washington for even greater powers and exemptions, the Fed Board and other regulatory agencies were either caught unaware or actively supported the expansion of the OTC market for subprime debt and derivatives.”

Sure, mortgage brokers making liar loans in FL were partly to blame for the mortgage crisis of the 2000s, but as my friends Josh Rosner and Gretchen Morgenson documented so well in the 2012 book “Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time,” Wall Street certainly must share the credit for this catastrophe with a generation of policy makers in Washington.  The monopoly position of the big banks and GSEs, combined with the infinite leverage of unregulated credit derivatives, are equal factors in the story. 

Don’t get me wrong, Michael Lewis is a fabulous writer and author, and “The Big Short” is a great book and an even better movie.  We owe Lewis, McKay and everyone involved with this film a debt of gratitude for telling at least part of the story of the financial crisis and telling it so well.  Indeed, as my new wife Nicole and I walked around Paris over Christmas, we saw lines of people waiting to see The Big Short, an appropriate scene given the role of some of the largest French banks in creating complex derivatives based upon American subprime mortgage debt. 

If my vote counts, The Big Short deserves a lot of awards for both the acting and the directing of a very complex story.  But never forget that derivatives like credit default swaps are the fuel that turned a mere bubble in the US housing market into a global financial meltdown, the effects of which are still being felt eight years later.